Preventing another financial fire

The global financial crisis has inspired people to think of protections for the future, but it seems convincing people to study prevention methods is less enticing than analyzing the catastrophe

By Robert Shiller

Illustration: Yusha

If we have learned anything since the global financial crisis peaked in 2008, it is that preventing another one is a tougher job than most people anticipated. Not only does effective crisis prevention require overhauling our financial institutions through creative application of the principles of good finance, it also requires that politicians and their constituents have a shared understanding of these principles.

Today, unfortunately, such an understanding is missing. The solutions are too technical for most news reporting aimed at the general public. While people love to hear about reining in or punishing financial leaders, they are far less enthusiastic about asking these people to expand or improve financial-risk management.

However, because special-interest groups have developed around existing institutions and practices, the public is basically stuck with them, subject to minor tweaking.

The financial crisis, which is still ongoing, resulted largely from the boom and bust in home prices that preceded it for several years — home prices peaked in the US in 2006. During the pre-crisis boom, home buyers were encouraged to borrow heavily to finance undiversified investments in a single home, while governments provided guarantees to mortgage investors. In the US, this occurred through implicit guarantees of assets held by the Federal Housing Administration (FHA) and the mortgage agencies Fannie Mae and Freddie Mac.

At an American Economic Association’s session at a recent meeting in Philadelphia, the participants discussed the difficulty of getting any sensible reform out of governments around the world. In a paper presented at the session, New York University professor of economics Andrew Caplin spoke of the public’s lack of interest or comprehension of the rising risks associated with the FHA, which has been guaranteeing privately-issued mortgages since its creation during the housing crisis of the 1930’s.

Caplin’s discussant, Wharton School real estate professor Joseph Gyourko, concurred. Gyourko’s study last year concluded that the FHA, now effectively leveraged 30 to one on guarantees of home mortgages that are themselves leveraged 30 to one, is underwater to the tune of tens of billions of dollars. He wants the FHA shut down and replaced with a subsidized saving program that does not attempt to compete with the private sector in evaluating mortgage risk.

Similarly, Caplin testified in 2010 before the US House of Representatives Committee on Financial Services that the FHA was at serious risk, a year after FHA Commissioner David Stevens told the same committee that “We will not need a bailout.”

Caplin’s research evidently did not sit well with FHA officials, who were hostile to Caplin and refused to give him the data he wanted. The FHA has underestimated its losses every year since, while proclaiming itself in good health. Finally, in September last year, it was forced to seek a government bailout.

At the session, Caplin was asked about his effort, starting with his co-authored 1997 book, Housing Partnerships, which proposed allowing home buyers to buy only a fraction of a house, thereby reducing their risk of exposure without putting taxpayers at risk. If implemented, his innovative idea would reduce homeowners’ leverage.

However, while it was a highly leveraged mortgage market that fueled the financial crisis 11 years later, the idea, he said, has not made headway anywhere in the world. It was then asked why creative people with their lawyers cannot simply create such partnerships for themselves?